Big fruit and low-hanging fruit
By Scott Sumner
Tyler Cowen recently linked to a George M. Constantinides study of the welfare costs of unstable consumption:
I estimate welfare benefits of eliminating idiosyncratic consumption shocks unrelated to the business cycle as 47.3% of household utility and benefits of eliminating idiosyncratic shocks related to the business cycle as 3.4% of utility. Estimates of the former substantially exceed earlier ones because I distinguish between idiosyncratic shocks related/unrelated to the business cycle, estimate the negative skewness of shocks, target moments of idiosyncratic shocks from household-level CEX data, and target market moments. Benefits of eliminating aggregate shocks are 7.7% of utility. Policy should focus on insuring idiosyncratic shocks unrelated to the business cycle, such as the death of a household’s prime wage earner and job layoffs not necessarily related to recessions.
That seems plausible to me. So why do I focus on the business cycle?
Although business cycles have a smaller impact on welfare, they are also much easier to address with public policy. There are nearly costless solutions for reducing the welfare costs of business cycles, such as NGDP level targeting. In contrast, we don’t have anywhere near as much knowledge about the best way to reduce idiosyncratic consumption volatility. To be sure, there are programs that try to do this, such as unemployment insurance. But it’s really hard for the government to design programs that are cost effective. That doesn’t mean that we shouldn’t try, just that the solutions are not obvious.
I’m attracted to business cycle research because it seems like a low hanging fruit. Maybe not the biggest fruit on the tree, but the easiest one to pluck with one hand.